Global Economics Eco 6367 Dr. Vera Adamchik

1. Global EconomicsEco 6367Dr. Vera Adamchik Foundations of Modern Trade Theory: Comparative Advantage

2. Key questions about trade • Why do countries trade? More precisely, what determines the pattern of trade (what is exported and what is imported)? • How does trade affect the economic well-being of each country? • How does trade affect the distribution of economic well-being or income among various groups within the country?

3. Why do countries trade? • Demand and supply conditions differ between countries, so prices differ between countries if there is no international trade. Trade begins as someone conducts arbitrage to earn profits from the price difference between previously separated markets.

4. Why would product prices differ with no trade? • Production conditions differ (technology, factor endowment, differences across products in the use of productive factors in producing the products) – the relative shapes of the PPFs differ between countries. • Demand conditions differ. • Some combination of these two differences.

5. While trade can be driven by differences in demand, most of our attention is on production-side differences. Production-side differences cause the countries’ PPFs to skew in different ways, reflecting different comparative advantages. • Sources of production-side differences: • differences in technologies or factor productivities; • differences in factor endowments and differences across products in the use of productive factors in producing the products.

6. Leading theories of trade Chapter 2: • Mercantilism (gold and silver). • Adam Smith’s theory (absolute advantage). • David Ricardo’s theory (comparative advantage). • The standard modern theory of trade (increasing marginal costs). Chapter 3: 5. The Heckscher-Ohlin theory (factor endowment & factor-use).

7. Leading theories of trade (cont.) 6. Product life-cycle theory (dynamic theory of technology and trade). 7. Stolper-Samuelson Theorem 8. New trade theory (scale economies) - monopolistic competition & product differentiation; - substantial internal scale economies and global oligopoly; - external scale economies (industries that concentrate in a few places). 9. Gravity model of trade (a country’s size, distance between countries, impediments to trade).

8. 1. Mercantilism

9. Mercantilism: Older than Smith and Alive Today • Mercantilism was the philosophy that guided European thinking about international trade in the several centuries before Adam Smith published his “Wealth of Nations” in 1776.

10. Mercantilists viewed international trade as a source of major benefits to a nation. • Merchants engaged in trade, especially those selling exports, were good – hence the name mercantilism. • A central belief of mercantilism was that national well-being or wealth was based on national holdings of gold and silver. • Given this view of national wealth, exports were viewed as good and imports (except for raw materials not produced at home) were seen as bad.

11. If a country exports more than imports, the gain in gold and silver increases the country’s well-being. • Also, gold and silver accruing could be especially valuable in maintaining a large military for the country. • Imports are undesirable because they reduce the country’s ability to accumulate gold and silver. • In addition, imports were feared because they might not be available to the country in time of war.

12. Mercantilists maintained that government regulation of trade was necessary to provide the largest national benefits. • Based on mercantilist thinking, governments, (1) imposed an array of taxes and prohibitions to limit imports; and (2) subsidized and encouraged exports.

13. A zero-sum game • Because of its peculiar emphasis on gold and silver, mercantilism viewed trade as a zero-sum activity – one country’s gains come at the expense of some countries, since a surplus in international trade for one country must be a deficit for some other(s).

14. Criticism • Before Adam Smith, David Hume showed that the goal of acquiring gold and silver can be self-defeating if this acquisition expands the domestic money supply and leads to domestic inflation of product prices. • Adam Smith and economists after him pointed out that mercantilist thinking turns social priorities upside down (will be discussed later – see slides # 26-28).

15. Still alive • Mercantilist thinking is very much alive today. It now has a sharp focus on employment. Neo-mercantilists believe that exports are good because they create jobs in the country, and imports are bad because they take jobs from the country. Neo-mercantilists continue to depict trade as a zero-sum activity.

16. In the late 18th and early 19th centuries, first Adam Smith and then David Ricardo explored the basis for international trade as part of their efforts to make a case for international trade. Their writings were responses to the doctrine of mercantilism prevailing at the time.

17. 2. Adam Smith’s theory of absolute advantage

18. In his “Wealth of Nations”, Adam Smith promoted free trade by comparing nations to households: It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost … more to make than to buy. The tailor does not attempt to make his own shoes, but buys them from the shoemaker… • Hence, every country should produce a specific product if this country is better than the rest of the world at producing this product.

19. What do we mean by “better at producing”? • We can indicate each country’s ability to produce a product as (i) labor productivity, that is, the number of units of output per hour or (ii) the number of hours it takes a worker to produce one unit of output. • Country with a higher labor productivity is said to have an absolute advantage in producing the good.

20. Adam Smith showed the benefits from free trade by showing that global production efficiency is enhanced because trade allows each country to exploit its absolute advantage. • At least one country is better off with trade (not at the expense of the other country); in many cases both countries will gain from trade.

21. In-class exercise • Exercise # 1 (handout).

22. Criticism • Yet Smith’s arguments failed to address the following fears: What if a country has no absolute advantage? What if the foreigners are better off at producing everything than we are? Will they want to trade? If they do, should we want to? • We turn next to the theory that first answered these fears and established a fundamental principle of international trade.

23. 3. David Ricardo’s theory of comparative advantage

24. David Ricardo’s main contribution to our understanding of international trade was to show that there is a basis for beneficial trade whether or not countries have any absolute advantage. • Ricardo carefully examined the concept of opportunity cost and demonstrated the principle of comparative (meaning “relative” and “not necessarily absolute”) advantage.

25. In-class exercise • Exercise # 2 (handout)

26. Key points that refute mercantilist thinking 1. National well-being is based on the ability to consume products now and in the future. Imports are part of the expanding national consumption that a nation seeks, not an evil to be suppressed.

27. Key points that refute mercantilist thinking 2. The importance of national production and exports is only indirect. They provide the income to buy products to consume. Exports are not desirable on their own; rather, exports are useful because they pay for imports.

28. Key points that refute mercantilist thinking 3. Trade freely transacted between countries generally leads to gains for all countries – trade is a positive-sum activity.

29. In-class exercise • Exercise # 3 (handout): Comparative Advantage Extended to Many Products and Countries

30. Criticism: Simple theories of trade rely on a set of many unrealistic assumptions (see p. 32). Among others: • A simple world in which there are only two countries and two goods. • In each nation, labor is the only input, fixed and homogeneous. • Labor can move freely from the production of one good to another good within a country, but cannot move between nations. • The level of technology is fixed for both nations.

31. 5. Costs do not vary with the level of production and are proportional to the amount of labor used (that is, constant returns to scale). In reality, both diminishing and increasing returns to specialization exist.

32. 4. The standard modern theory of trade (based on increasing marginal costs)

33. This extension of the Ricardian model relaxes assumption #3 and #5 (on page 32). • The standard theories of trade (that is, Smith and Ricardo) assume constant returns to scale (CRS). With CRS, average cost does not change when the quantity of output changes, assuming both adjustments of all factor inputs and constant factor input prices.

34. In reality, however, many industries incur rising, rather than constant, marginal opportunity costs. Reasons: (1) Resources are specialized, of different quality, and do not always move easily from one economic activity to another. (2) Different goods use resources in different proportions.

35. For instance, efforts to expand U.S. wheat production would fairly quickly run into rising costs caused by limits on (1) how much more land could be drawn into wheat production and how suitable this additional land would be for wheat production; (2) the availability of additional workers willing and suitable to work on the farms; (3) the availability of seeds, fertilizers, and other material inputs.

36. Hence, as one industry expands at the expense of others, increasing amounts of the other products must be given up to get each extra unit of the expanding industry’s product. • Increasing marginal costs are illustrated by a “bowed-out” PPF.

37. The PPF with increasing opportunity costs / diminishing returns The PPF tells us how much of one good we must sacrifice in order to make available the resources to produce one more of the other good.

38. In-class exercise • Exercise # 4 (handout): Example with a non-linear PPF.

39. The standard modern theory of trade shows that it is not feasible for a country to specialize to the degree suggested by the simple trade theories. The gains from specialization are likely to be exhausted before specialization is complete. In reality, most countries do not specialize but, instead, produce a range of goods. • The basic conclusion that unrestricted free trade is beneficial still holds, although the gains may not be as great as suggested in the constant returns case.

40. Criticism • Comparative-advantage theory of trade focuses on technology or resource productivity differences as a production-side basis for trade / comparative advantage. • According to comparative-advantage theory, nations that are similar in their production-side capabilities (and in their general demand patterns) should trade little with each other. • In reality, we observe the opposite.

41. Industrialized countries (which are similar in many aspects in their technologies, technological capabilities, and factor endowment) trade extensively with each other. • Trade between industrialized countries is nearly half of all world trade. • Over 70% of the exports of industrialized countries go to other industrialized countries, and about 4/5 of these exports are nonfood manufactured products. • These facts appear to be inconsistent with comparative-advantage theory.

42. Furthermore, technology quickly spreads internationally because it is difficult for a country to keep its technology secret. Hence, many countries usually have access to the same technologies for production and are capable of achieving similar levels of resource productivity. • We turn next to the theory that focuses on another important source of production-side differences (that is, international differences in the shapes of bowed-out PPFs).